Business Insurance Part 1 Working with Business Owners

1. Business Insurance Part 1 Working with Business Owners A PARTNER YOU CAN TRUST. Jorge Ramos, CFP ,CLUDirector of Advanced Marketing 1

2. Business Structures and Taxation A PARTNER YOU CAN TRUST. 1

3. Business Structures • Self Employed • Partnerships • Incorporated private business • CCPC • Publicly listed corporation • Professional Corporations

4. Business Taxation 101 • Self Employed • Commission income or sales • Can deduct expenses • Net profit taxed as personal income • Partnerships • Commission income or sales • Can deduct expenses • Net profit added taken as income proportionately by each partner

5. Business Taxation 101 • Incorporated Private business • General corporate tax rates • 26% (11% Provincial, 15% Federal) • 25% (manufacturing, farming, mining) • CCPC • 15.5% (4.5% Federal, 11% Provincial) • On first $500,000 • Publicly Traded companies • Do not qualify as CCPC

6. Canadian Controlled Private Corporation • CCPC • Corporation resident in Canada • 51% controlled by Canadians • Not listed on a stock exchange • Not owned by a publicly traded firm

7. CCPC - Advantages • Lower corporate tax rates • 15.5% vs. 26% • An additional month to pay taxes • Enhanced investment tax credits • Qualifies for Capital gains exemption - CGE • First $750,000 of capital gains on shares is tax-free

8. Capital Gains Exemption • First $750,000 of capital gains are tax-free • Qualified small business shares • Qualified Farm property • 50% of assets “actively” used in the business for the last 24 months • 90% of assets “actively” used in the business at time of sale • Shares owned by individual for last 24 months

9. Publicly Listed Corporation • Everyone is an employee, including Founder • Company can own Life insurance on employees • Requires resolution of the board • Insurance premiums not tax deductible

10. Professional Corporations A PARTNER YOU CAN TRUST. 1

11. Professional Corporations • Can only carry on business of profession • Majority must be owned by professionals (voting shares) • Non-professional spouse/children can also be shareholders (non-voting shares) • Cannot be a numbered company

12. When to set-up a Professional Corp • Income higher then needed for lifestyle • No personal non-deductible debts • In highest personal tax bracket • Spouse and children in lower tax brackets • Creditor protection needed • Deductions against income needed

13. Professional Corp. – Advantages • Qualifies for small business tax rates • Expenses deduction • Tax deferral • Corporate tax vs. personal tax rates • Dividend vs. salary • Income splitting • Hiring family members • Dividend sprinkling • Creditor Protection

14. Professional Corp. - Disadvantages • CGE – triggered on sale of shares • Cannot sell professional corp. shares easily • No protection against Professional negligence • Increased costs to administer • Increased regulation and complexity • Employee health tax charged on income • Business losses cannot be flowed to shareholders

15. The Mechanics of Corporate Policies A PARTNER YOU CAN TRUST. 1

16. Theory of Tax Integration • Income earned at a corporate level may ultimately end up being distributed to someone and as a bonus/income or as a dividend to someone personally. • Income should be Tax Neutral, ie: taxed equally whether income is earned corporately or personally. • There are various mechanisms used by CRA to ensure that this is true: • RDTOH – Refundable Dividend tax on hand • CDA – Capital Dividend Account

17. RDTOH – Refundable Dividend Tax on Hand • Acts as a disincentive to accumulate investment income in the corporation. • The federal government levies a tax on any investment income earned by a CCPC, the tax goes into the company’s RDTOH account (functioning like an inventory) with CRA and is refunded to the CCPC when it pays a taxable dividend to shareholders. • For every $3 in taxable dividends that are paid to shareholders, the company is refunded $1 up to the balance of the RDTOH account.

18. CDA - Capital Dividend Account • The CDA is a notional account. • It is not an actual bank account but rather an accounting notation • The CDA tracks any amounts that a company receives tax free, such as: • Insurance death benefits, net of ACB • Tax-free portion of capital gains • Capital dividends received • The CDA amount allows the corporation to pay a tax-free capital dividend from their retained earnings. • Must be paid to a CDN resident • Must be a CCPC – CDN controlled private Corp.

19. Calculating CDA • CDA = Life insurance death benefit – ACB • Life insurance death benefit • net of policy loans • not net of collateral loans • Applies to permanent and Term policies • Applies whether there is cash value or not • Notes: • ACB usually goes to zero after 20+ years, cannot be negative • CDA has to be paid out equally to all shareholders of the same class

20. ACB • ACB – Adjusted Cost Basis • Ensures that corporate money gets taxed properly in personal hands • The ACB of policy tracks the original premium paid by a company for life insurance minus the NCPI • Formula • Premiums Paid increase ACB • NCPI decreases ACB

21. NCPI • NCPI – Net Cost of Pure Insurance • Net amount at risk (NAAR) for the year multiplied by the probability of death in that year, ie: similar to T1 rates • Based on 1975 Select and Ultimate mortality table • Costs for any benefits or riders removed • Removes any ratings on substandard risks

22. Calculating CDA • CDA = Life insurance death benefit – ACB • Life insurance death benefit • net of policy loans • not net of collateral loans • Applies to permanent and Term policies • Applies whether there is cash value or not • Notes: • ACB usually goes to zero after 20+ years, cannot be negative • CDA has to be paid out equally to all shareholders of the same class

23. Impact of CDA • Client Male 50, Std. NS, Corp. • Policy Death benefit $5 million UL face only • Premium $200,000 per year for 10 year • Min Level COI Cost $66,219.24 • ACB in year 5 $ 945,709 • ACB in year 20 $1,333,791 • ACB in year 30 $ 0 NCPI vs COI ($54,291 vs $331,096) ($666,209 vs $2 million)

24. Impact of CDA – Year 5 • Death Benefit $5,000,000 • ACB $ 945,709 • CDA Credit $4,054,291 • How much did Corp. receive from InsCo.? • $5,000,000 • How much could Corp pay tax free to shareholders? • $4,054,291 • What happens to the rest?

25. Impact of CDA – Year 5 • Death Benefit $5,000,000 • ACB $ 945,709 • CDA Credit $4,054,291 • Tax free Capital dividend paid $4,054,291 • Taxable dividend paid $ 945,709 • Tax paid on dividend $ 308,017 • What is the net death benefit received by shareholders? • $4,691,983

26. CDA Tax Trap • Problem: • Potential death benefit shortfall created by CDA/ACB • Net death benefit may fall short of required amount • Buy-sell • Solution: • Face plus fund plus ACB • Increases face amount so that CDA paid is equal to or greater than original death benefit • Removes risk of the ACB tax grind on CDA • Removes risk of underinsuring the need

27. Accounting for Corporate Owned Policies A PARTNER YOU CAN TRUST. 1

28. Deductibility of Insurance Premiums • Premiums paid by a corporation for a life insurance policy are generally not tax deductible • Considered a capital outlay and not an expense • Exceptions: • Group insurance premiums • Charitable gifting of a life insurance policy • Collateral insurance

29. 1. Group Insurance Premiums • Group medical insurance • Group life insurance • IPP’s • RCA’s

30. 2. Charitable gifting of a life insurance policy • Policy assigned to charity • Charity issues a tax receipt equal to actual premiums paid • Death benefit does not trigger a tax receipt • Policy not assigned to charity • Charity issues a tax receipt for value of death benefit upon receipt of death benefit proceeds • No tax receipt for annual premiums

31. 3. Collateral Insurance • Client secures a loan from a restricted financial institution • Lender requires a policy as collateral to secure the loan • The policy is assigned to the lender • Loan proceeds are invested in a qualified income generating investment • Interest on loan must be tax deductible

32. Collateral Insurance - Interest Deductibility • Loans must be invested to earn income • Rent, dividends, profit, interest • Capital gains does not qualify • Interest must be paid or payable in the year • There must be a legal obligation to pay the interest • Interest deduction can only be taken by policy owner • Policy loan interest must be confirmed by insurer • Form T2210

33. Collateral Insurance – Allowable deduction • Step 1 • Lower of: • NCPI for the year and • Premiums actually paid in the year • Step 2 • Pro-rated by amount applicable to loan • Example: Loan Amount = $250,000 Insurance DB = $1 million Deductible amount = 25% of step 1 amount

34. MTAR • Maximum Tax Actuarial Reserve • Magical Table of Allowable Room • The maximum premium a policy owner can deposit into a policy, tax sheltered. • The maximum amount that an insurance company can claim as a policy reserve.

35. MTAR - Two Major Tests • Exempt Test Policy (ETP) • designed to measure the funding level of a life insurance policy relative to its death benefit • 250% or “Anti Dump-In” Rule • applies if the accumulating fund on the tenth anniversary or any subsequent anniversary date, exceeds 250% of accumulating fund on the third preceding anniversary date

36. Exempt Test Policy (ETP) • Based upon the actuarial reserves required for a 20 pay policy to endow (cash surrender value equal to death benefit) at age 85

37. Issues with Exempt Test • Rules in Regulation 306 of Tax Act outlining exempt policies are open to interpretation • Based on CSV or Fund Value ?? • Increase in Fund value considered new deposit ?? • Test ends at age 85 • No insurance needed to tax shelter funds • Changes coming in 2014

38. 250 percent rule (anti dump-in rule) • 10th year test • Maximum deposit in year 10 is • Year 7 Fund value times 250% • Growth in fund value is considered new money • Prior to 7th Year • Need to start contributing more than the minimum

39. Corporate Financial Statements A PARTNER YOU CAN TRUST. 1

40. Income Statement • Premiums paid minus increase in CSV = Net Insurance Expense • Increase in CSV minus premiums paid = Income

41. Balance Sheet • Cash surrender value of policy = Asset

42. Corporate Minutes • Approve purchase of Life insurance • Key-Man • Buy-Sell • IPP/RCA • IRIS

43. Financial notes Notes to reflect that policy pledged as collateral

44. Advantages of Corporate Owned Life Insurance A PARTNER YOU CAN TRUST. 1

45. Corporate Insurance Advantages • Personal marginal tax rates vs. Corporate rates • 46.4% vs. 15.5% • Ease of administration • Buy-Sell premiums shared equally • Multiple policies centrally owned • Capital dividend account

46. Disadvantages of Corporate Owned Life Insurance A PARTNER YOU CAN TRUST. 1

47. Corporate Insurance Disadvantages • CDA Tax trap • Increased value to corporate shares • Increases capital gain • Opco vs. Holdco • Potential sale of Opco • CCPC/CGE offside risk

48. Thank You Jorge Ramos, CFP, CLU Director of Advanced Marketing 416-206-7050 jorge.ramos@inalco.com